Market risk

What is Market risk?

Market risk is the risk of losses in positions arising from movements in market prices.

Market risk is the possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets in which he is involved. Market risk, also called “systematic risk,” cannot be eliminated through diversification, though it can be hedged against. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks.

Market Risk is also referred to as systematic risk or non-diversifiable risk.

Market risk is comprised of the “unknown unknowns” that occur as a result of everyday life. It is unavoidable in all risky investments. It can also be thought of as the opportunity cost of putting money at risk.

There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most commonly used types of market risk are:

  • Equity risk, the risk that stock or stock indices (e.g. Euro Stoxx 50, etc. ) prices or their implied volatility will change.
  • Interest rate risk, the risk that interest rates (e.g. Libor, Euribor, etc.) or their implied volatility will change.
  • Currency risk, the risk that foreign exchange rates (e.g. EUR/USD, EUR/GBP, etc.) or their implied volatility will change.
  • Commodity risk, the risk that commodity prices (e.g. corn, crude oil) or their implied volatility will change.
  • Margining risk results from uncertain future cash outflows due to margin calls covering adverse value changes of a given position.
  • Shape risk.
  • Holding period risk.
  • Basis risk.

Risk management

All businesses take risks based on two factors: the probability an adverse circumstance will come about and the cost of such adverse circumstance. Risk management is the study of how to control risks and balance the possibility of gains.

Measuring the potential loss amount due to market risk

As with other forms of risk, the potential loss amount due to market risk may be measured in a number of ways or conventions. Traditionally, one convention is to use value at risk (VaR). The conventions of using VaR are well established and accepted in the short-term risk management practice.

However, VaR contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the specified period. Over short time horizons, this limiting assumption is often regarded as reasonable. However, over longer time horizons, many of the positions in the portfolio may have been changed. The VaR of the unchanged portfolio is no longer relevant. Other problematic issues with VaR is that it is not sub-additive, and therefore not a coherent risk measure. As a result, other suggestions for measuring market risk is Conditional Value-at-Risk (CVaR) that is coherent for general loss distributions, including discrete distributions and is sub-additive.

The Variance Covariance and Historical Simulation approach to calculating VaR assumes that historical correlations are stable and will not change in the future or breakdown under times of market stress. However these assumptions are inappropriate as during periods of high volatility and market turbulence, historical correlations tend to break down. Intuitively, this is evident during a financial crisis where all industry sectors experience a significant increase in correlations, as opposed to an upwards trending market. This phenomenon is also known as asymmetric correlations or asymmetric dependence. Rather than using Historical Simulation, Monte-Carlo simulations with well-specified multivariate models are an excellent alternative. For example, to improve the estimation of the Variance Covariance matrix, one can generate a forecast of asset distributions via Monte-Carlo simulation based upon the Gaussian copula and well-specified marginals. Allowing the modeling process to allow for empirical characteristics in stock returns such as auto-regression, asymmetric volatility, skewness, and kurtosis is important. Not accounting for these attributes lead to severe estimation error in the correlation and Variance Covariance that have negative biases (as much as 70% of the true values). Estimation of VaR or CVaR for large portfolios of assets using the Variance Covariance matrix may be inappropriate if the underlying returns distributions exhibit asymmetric dependence. In such scenarios, vine copulas that allow for asymmetric dependence (e.g., Clayton, Rotated Gumbel) across portfolios of assets are most appropriate in the calculation of tail risk using VaR or CVaR.

In addition, care has to be taken regarding the intervening cash flow, embedded options, changes in floating rate interest rates of the financial positions in the portfolio. They cannot be ignored if their impact can be large.

Value at Risk

To measure market risk, investors and analysts use the value at risk method. The value at risk method is a well known and established risk management method, but it comes with some assumptions that limit its correctness. For example, it assumes that the makeup and content of the portfolio being measured is unchanged over a provided period. Though this may be acceptable for short-term horizons, it may provide less accurate measurements for long-term horizons of investments, because it is more exposed to changes in interest rates and monetary policies.

Market risk can also be contrasted with Specific risk, which measures the risk of a decrease in ones investment due to a change in a specific industry or sector, as opposed to a market-wide move.

Major components of market risks

The major components of market risk include:

  • Interest rate risk.
  • Equity risk.
  • Foreign exchange risk.
  • Commodity risk.

Interest rate risk

It’s the potential loss due to movements in interest rates. This risk arises because a bank’s assets usually have a significantly longer maturity than its liabilities. In banking language, management of interest rate risk is also called asset-liability management (or ALM).

Equity risk

It’s the potential loss due to an adverse change in the stock price. Banks can accept equity as collateral for loans and purchase ownership stakes in other companies as investments from their free or investible cash. Any negative change in stock price either leads to a loss or diminution in investments’ value.

Foreign exchange risk

It’s the potential loss due to change in value of the bank’s assets or liabilities resulting from exchange rate fluctuations. Banks transact in foreign exchange for their customers or for the banks’ own accounts. Any adverse movement can diminish the value of the foreign currency and cause a loss to the bank.

Commodity risk

It’s the potential loss due to an adverse change in commodity prices. These commodities include agricultural commodities (like wheat, livestock, and corn), industrial commodities (like iron, copper, and zinc), and energy commodities (like crude oil, shale gas, and natural gas). The commodities’ values fluctuate a great deal due to changes in demand and supply. Any bank holding them as part of an investment is exposed to commodity risk.

Market risk is measured by various techniques such as value at risk and sensitivity analysis. Value at risk is the maximum loss not exceeded with a given probability over a given period of time. Sensitivity analysis is how different values of an independent variable will impact a particular dependent variable.